A Credit Policy Crafted For Macro-economic Stability

Updated: Nov 4 2003, 05:30am hrs
There were surprises in Mondays Credit Policy statement. Most people, including this columnist, had expected a cut in the repo rate. Some had expected cuts in the cash reserve requirement (CRR) and a few in the bank rate as well. In the event, all three were left unchanged. The new governor of the Reserve Bank of India (RBI) has clearly signalled a change in course. There is adequate liquidity in the system, the RBI feels as evident in the steep increase in the excess funds parked by banks with it [para 20]. So, no further cut in the CRR for the moment. Having said that the statement specifically asserts that the RBI will continue to ensure that adequate liquidity is maintained in the system so that all legitimate requirements for credit are met consistent with the objective of price stability.

On the price front, RBI envisages that for policy purposes inflation by end-March 2004 will be in the range of 4.0-4.5 per cent, with a possible downward bias. Pertinently the RBI would continue to closely monitor the price behaviour leaving no room for complacency on the inflation front [para 16]. With a rising rupee and prospective reductions in effective tariff protection attendant on the operationalising of the free trade agreements (FTA) with Thailand, Singapore and other South-East Asian countries, average inflation rates of 4 to 5 per cent is plain uncomfortable. Inflation is around 2 per cent in the developed world and lower in many Asian economies.

Why no cut in the bank rate (BR) That is easy to answer. Because while the BR has become de-linked to anything, it has in the perception of the bond market acquired precursor status signalling future interest rate reductions; perhaps an unintended outcome. However, instead of burying the BR, the RBI has linked it to the rate at which foreign banks will deposit their shortfalls in priority sector lending with the Small Industries Development Bank of India (SIDBI).

The repo rate at 4.5 per cent is way above short-term rates world-wide. Then, why has the repo rate been kept where it is That is a far more difficult one to answer. My understanding runs as follows. Cutting the repo rate would have been the conventional response to the present interest rate differentials at the short-end of the yield curve in Indian and overseas bond markets and would depress the rupee vis--vis major currencies. But the conventional logic assumes full capital convertibility and capital flows only in the form of short-term money invested in fixed interest securities. In the ideal world of such thinking, a short-term rate cut would also translate into lower borrowing costs for industry and commerce.

We, however, do not have full capital account convertibility. The only uncapped short-term flows which can react to interest rate differentials are Non-resident Indian (NRI) deposits. That has been already slashed to a mere 25 bps over LIBOR. All of the other flows on the capital side, aside from foreign direct investment, are either into equity assets or commercial loans to Indian enterprises. Equity flows are being driven by perceptions of the fundamentals of the Indian economy and the profitability of its corporate sector, and therefore, is not going to be influenced by changes in interest rates. As regards external commercial borrowings, the RBI has stepped up the pressure for hedging these exposures, mandating it for such loans when extended by banks under its supervision [para 65]. Greater buying of forward dollars would help restore balance to the forward premium structure.

As regards, borrowing costs, the experience has been that repo rate cuts have not travelled to proportionately lower borrowing costs for small and medium enterprises, as seamlessly as they have travelled (unintended perhaps) up the maturity of the government security yield curve. The problems here are institutional and have to be addressed as such. So the Credit Policy has loads of stuff on dealing with improvements in the institutional set-up for delivering small credit.

The statement says, in order to fully exploit the emerging opportunities in the agricultural, small and medium scale industrial sectors there is a need to further improve institutional as well as incentive mechanisms in banks to strengthen credit delivery to SMEs, infrastructure and agriculture [para 32f]. A preview of changes in the institution of channelling bank loans to small businesses is already there in this Credit Policy. In an innovative step, loans granted extended by banks to non-bank finance companies (NBFCs) for on-lending to small scale industries will be treated as priority sector lending [para 52].

Finally, a repo cut would certainly have travelled up the yield curve with an equivalent fall in long-term yields an undesirable outcome. This negative certainty, in the RBIs view outweighed any gains from other quarters. Hence the repo rate stayed put.

The author is economic advisor to ICRA (Investment Information and Credit Rating Agency)